Asian Paints - Leading the way

Farmers across Maharashtra, Chhattisgarh and Telangana celebrate a rather unique festival in honour of the bulls that help till their land. They decorate their bulls with ornaments and silk, paint their horns and put up a very colourful spread of bovines. However back in the old days, painting a bull’s horn in bright colours and procuring them in such small quantities proved to be a particularly difficult challenge. This is when Champaklal Choksey, a budding entrepreneur found both a need gap and an interesting opportunity to expand his business.

What began as a dream soon gave way to unbridled ambition culminating in the company becoming the largest paint manufacturer in the country, so large that when it was re-inducted into the Nifty 50 index (a benchmark list of stocks, that is expected to reflect the current state of Indian markets) in 2012, it boasted sales of over 10,000 crores and profits of over a 1,000 crores. Our story today is an attempt to understand Asian Paints, a behemoth in its own right and one of the most expensive paint stocks in the world.

But before we get into dissecting why the company stands tall among giants, we must address a very real concern — Real Estate.

The Death of Real Estate

There have been persistent rumours about the Real Estate industry being on the verge of collapse. These industries usually operate in cycles described by a sustained increase in real estate prices, during which all the stakeholders in the ecosystem flourish, followed by a sustained depression in prices when there is a lull in the market. Based on current data, it seems Real Estate isn’t in the best of shapes and this has created a new problem, a problem characterized by a mismatch in demand and supply. There are about 1,20,000 apartments in Pune lying unsold and another 1,00,000 units in Bengaluru. So if Real Estate is in such dire straits its perhaps reasonable to assume that Asian Paints will also see a marked decline in its sales income, considering about 90% of the products sold by the company (domestically) goes into painting homes and there aren't enough people enthusiastic about building homes in the first place.

Well, that would be the first logical conclusion if only Asian Paints depended on new constructions for sales. In fact, it so happens that a significant chunk (90%) of its revenue comes from repainting existing homes as opposed to painting new ones. So even if there was a significant slowdown in the real estate sector, it would hamper growth, no doubt, but its effects on Asian Paints is perhaps still going to be of little significance considering the folks who are out to repaint their homes care precious little about real estate prices or the health of the real estate sector in the first place. Also, while the real estate sector has been on the decline, most of this decline has been premised on builders focusing on the mid-category and premium segments. Affordable housing, on the other hand, has been on the rise. Now, discussions about margins and whether Asian Paints will be able to successfully capture this market is another matter, but perhaps its safe to say that things have been blown slightly out of proportion when it comes to the death of Real Estate. So what sets apart Asian Paints from the competition? Well, for starters, the company is really really good with its cash.

King of Cash

One of the most important markers of running a profitable business is efficient cash management. A metric that succinctly captures a part of this idea is the cash conversion cycle. The cash conversion cycle (CCC) depicts the time it takes for Asian Paints to convert its investments in making and storing paint in its warehouses into cash from sales. As a business, you would ideally want your customers to pay early while you try and bargain with your suppliers to reach an arrangement that allows you to pay them back at a much later date during which time you try and store as little inventory in your own warehouse. As you get better at this game of cat and mouse, you will have more free cash filling up your coffers, free cash that could then be used to invest elsewhere and improve sales. Asian Paints is a master at this game. It has a cash conversion cycle of a mere 6 days i.e. it only takes the company 6 days to recoup its investment in inventory and other resources through sales and generate cash in the process. A comparison with some of its peers highlights why Asian Paints dominates the competition the way it does.

But Asian Paints doesn’t sell to regular customers. It instead sells to dealers who in turn are trying to run their own businesses. Wouldn’t the dealers want to be more prudent with their cash? Why would they make swift payments to Asian Paints and hurt their prospects? Why not simply buy on credit and make payments at a much later date and improve their own cash conversion cycles. Well, they would do it if it weren’t for Asian Paints and its unparalleled ability to restock products on short notice. Dealers ask for credit periods because it takes time for them to find consumers who are willing to buy what they have in store. However, if paint companies can restock products in 2–3 days, the dealers won’t have to maintain large stocks, instead, replenish their stock based on actual customer orders and pay back the company as soon as they execute the sale. So this rather quaint number, cash conversion cycle is an exposition on more than just cash inflows and outflows, it also tells you about the relative distribution supremacy that the company holds over its competitors that enables it to command such favourable terms from both its suppliers and the dealers/customers.

Pro Tip: Monitoring this metric will help investors gauge the operational efficiency of Asian Paints as they continue to keep growing

Delayed Differentiation

Another way to look at the operational superiority of Asian Paints is to explore a rather obscure term in Supply Chain Management called Delayed Differentiation and see how the company is still miles ahead of the competition. Delayed Differentiation points to a technique where companies produce generic products and introduce differentiation at the end of the value chain. This might not make much sense until you apply the principle to the actual process of creating and delivering paint to the end consumer.

One of the most challenging aspects of the business is predicting latent demand for different shades of paint. It's perhaps next to impossible to forecast demand for thousands of shades of paint and so it is an extremely challenging task to meet the needs of the end consumer within a limited time frame. The usual process involves the dealer in question taking the request, forwarding it to the nearest depot or warehouse, where they mix and match the required shade of paint after which the supply is made available which could take anywhere between 10 to 20 days.

Now this laborious process can put off the most patient customers and so you need a quick fix. A simple workaround is to add or change the colour at the final step i.e. to introduce differentiation right before the customer buys it from the dealer. This idea of introducing colour at the final step exemplifies delayed differentiation. The dealers use special equipment called tinting machines to mix and match colours and produce the required shade inside store premise. Asian Paints pioneered this movement and it is now a mainstay of the paint industry. However, because Asian Paints operates at a scale far superior to its competitors it can extract more value. While Nerolac and Berger together deploy about 20,000 tinting machines through their dealer network, Asian Paints has about 43,000 at play, another testament to its superior distribution prowess.

But all of this alludes to the past. How should one predict the future of the stock?

Titanium Dioxide, Oil and the Rupee

One way to predict short time swings in stock price movement is to establish a correlation between the company’s input cost and the stock price. Although it isn't foolproof, it often employs a solid rationale. If it becomes more expensive to manufacture a product its likely to impact sales and so the stock price must decline given the prospects are no longer as plush as they used to be. However, Asian Paints does not conform to this logic and we will try and explain why. One of the key raw material used to manufacture paint is Titanium Dioxide (TiO2), a compound whose cost forms roughly about 20 % of the total raw material cost and because TiO2 prices are largely driven by demand alone, making paint ought to become more expensive as demand for TiO2 picks up.

We see the same pattern with crude oil. About 30–35% of the raw material cost can be attributed to products derived from crude oil and when the price of oil increases, we see a similar adjustment in the cost of raw material consumed. This is true with the exchange rates as well. Asian Paints imports about 30% of its raw materials, which means as the Rupee depreciates, it becomes more expensive to buy them and yet, we don’t see any of this consistently affecting the stock price. We believe that this anomaly could largely be attributed to two things.

For one, paint is relatively price-inelastic. which means any time there is an increase in the price, you don’t necessarily see a commensurate decrease in demand. When was the last time you walked into a store and figured you would paint your house at a later date because it's now more expensive to do so? This allows Asian Paints to pass on the increase in its cost to the consumer without having to worry too much about sales. But what if competitors like Nerolac were to pounce on this opportunity and make their offering more attractive by not hiking prices. This brings us to the second point in that you can find Asian Paints where no other alternative is available. The company has a dealer network far superior to its competitors making Asian Paints the only solution available in several stores across India rendering competition irrelevant. So will we ever see input cost affecting stock price?

Well, it’s quite possible that as competition increases, Asian Paints would no longer be able to pass on the increase in cost to the consumer. But they are making a conscious effort to avoid such scenarios playing out. For one, the company is moving towards water-based paints to reduce their dependence on crude oil derivates, an element of the cost structure that is prone to wild swings. It also continues to solidify its distribution network working on its dealer network and in the process avoiding potential hiccups, constantly improving sales numbers and boosting profit margins.

So what’s the catch here?

The P/E multiple conundrum

All good things come at a price, a price that sometimes might not seem reasonable to most people. You could buy Asian Paints (shares) at about Rs. 1300 a pop. The only way you could know if it’s reasonable is by looking at the earnings you are theoretically entitled to as a shareholder. Asian Paints made profits amounting to about 2000 crores last year which translates to earnings of about Rs. 21 per share. So based off of these numbers, if you wanted to buy a share today, you’d be paying about 60 times the earnings you are entitled to if you held a single share of the company. This idea is encapsulated in what is called the Price to Earnings (P/E) ratio and by all accounts, a P/E ratio of 60 is considered expensive and it has been a topic of much debate — whether investors are paying above and beyond what a large paint company deserves.

The naysayers almost always point to one argument — companies that command high P/E multiples are usually companies with significant potential for growth. However, despite a reasonable growth rate (sales), this number has been on a steady decline over the past few years. From 16% in 2014 to 4% in 2018, the numbers speak a very morbid tale. But perhaps its a bit disingenuous to state these numbers without context. For starters, demonetisation and GST have had a material impact on the whole industry. Growth rates have declined across the spectrum and with a new revision in tax rates (a reduction from 28% to 18%) the industry is expected to bounce back. Another factor that is rather obvious is the base effect i.e. it becomes increasingly harder to post exorbitant growth rates as the base level that is used to measure the change in growth keeps expanding. It's much easier for a Nerolac or a Berger to post higher growth rates because of their relatively smaller sales base, compared to a behemoth, the size of Asian Paints.

So while there is considerable merit in arguing that the stock might, in fact, be overpriced, investors must bear in mind that the P/E multiple must never be viewed in isolation for when Asian Paints was re-inducted into the Nifty 50 Index back in 2012, it was considered one of the most expensive paint stocks in the world, already commanding a P/E of 36 and the same arguments were made then. However, the stock has rallied since and now sells at an even higher premium.

The Bull Keeps Raging On

For its part, Asian Paints continues to invest in expanding and the results perhaps justify the high asking price for the stock. Return on Capital Employed (ROCE) for the company stands at about 39% i.e. for a hundred rupee it spends in growing the company it earns 39 rupees per year in return. It’s also making large strides into entering relatively new markets i.e. kitchenware. The company recently acquired Sleek, a kitchen hardware producer and Ess Ess, an bath fittings manufacturer that contribute about 2% to the total revenues. Although these are modest numbers, there are considerable potential upsides to this story.

The company also plans to double capacity (from 1.1 Trillion Litres to 2.2 Trillion Litres) over the next few years, half of which is expected to be operational by 2020. That’s enough paint to cover 60% of the surface of Moon and one might be inclined to think that with rising disposable incomes, government initiatives to boost housing and an ever-increasing frequency in repainting homes, you’d need all that paint.

But what's really central to the Asian Paints story is that despite being the giant that it is, it continues to pave way for others to follow. Rama Bijapurkar, one of India’s most respected thought leader in market strategy notes- “Asian paints is obsessed about hiring the best people, about having the best IT and the smartest technology-driven process.” It started hiring IIM graduates back in 1969 and had mainframe computers in the 70's to forecast demand. It installed automated warehousing systems (robots stacking up shelves & loading trucks) in 2008 and uses GPS on its vehicles to optimise its supply chain- all pointing to a culture of innovation and an insatiable desire to grow. So maybe the growth story is just beginning, maybe its the start of another grand bull run, maybe Asian Paints will still lead the way.